Hedged items General requirements

Hedged items General requirements discusses the eligible hedged item and risk components in non-financial items. The general requirements of what qualifies as an eligible hedged item are unchanged compared to IAS 39. A hedged item can be: Hedged items General requirements Hedged items General requirements

  • A recognised asset or liability Hedged items General requirements
  • An unrecognised firm commitment Hedged items General requirements
  • A highly probable forecast transaction Hedged items General requirements

Or  Hedged items General requirements

All of above can either be a single item or a group of items, provided the specific requirements for a group of items are met (see ‘Groups of items‘).

Only assets, liabilities, firm commitments and forecast transactions with an external party qualify for hedge accounting. As an exception, a hedge of the foreign currency risk of an intragroup monetary item qualifies for hedge accounting if that foreign currency risk affects consolidated profit or loss. In addition, the foreign currency risk of a highly probable forecast intragroup transaction would also qualify as a hedged item if that transaction affects consolidated profit or loss. These requirements are unchanged from IAS 39.

As with IAS 39, the item being hedged must still be reliably measurable. Also unchanged from IAS 39, a forecast transaction must be highly probable. However, what has changed in IFRS 9, compared to IAS 39, is how hedged items are designated in a hedging relationship. In particular, the designation of risk and nominal components and the designation of aggregated exposures and groups of items have changed. These changes, which should ultimately lead to more risk management activities qualifying for hedge accounting, all stem from the broader goal of the hedge accounting project, to better align an entity’s risk management approach with the accounting outcome.

Risk components of non-financial items

Under IAS 39, only risk components of financial items (such as the LIBOR rate in a loan that bears interest at a floating rate of LIBOR plus a spread) could be designated as a hedged item, provided they are separately identifiable and reliably measurable. Under IFRS 9, risk components can be designated for non-financial hedged items, provided the component is separately identifiable and the changes in fair value or cash flows of the item attributable to the risk component are reliably measurable. This requirement could be met where the risk component is either explicitly stated in a contract (contractually specified) or implicit in the fair value or cash flows (non-contractually specified).

Entities that hedge commodity price risk that is only a component of the overall price risk of the item, are likely to welcome the ability to hedge separately identifiable and reliably measurable components of non-financial items. Hedged items General requirements

Example: Contractually specified risk component

An example of a contractually specified risk component that we have come across in practice is a contract to purchase a product (such as aluminium cans), in which a metal (such as aluminium) is used in the production process. Contracts to purchase aluminium cans are commonly priced by market participants based on a building block approach, as follows:

  • The first building block is the London Metal Exchange (LME) price for a standard grade of aluminium ingot.
  • The next building block is the grade premium or discount to reflect the quality of aluminium used, as compared to the standard LME grade.
  • Additional costs will be paid for conversion from ingot into cans and delivery costs. Hedged items General requirements
  • The final building block is a profit margin for the seller. Hedged items General requirements

Many entities may want to use aluminium LME futures or forwards to hedge their price exposure to aluminium. However, IAS 39 did not allow just the LME component of the price to be the hedged item in a hedge relationship. All of the pricing elements had to be designated as being hedged by the LME future. This caused ineffectiveness, which was recorded within P&L; and, in some cases, it caused sensible risk management strategies to fail to qualify for hedge accounting. By contrast, IFRS 9 allows entities to designate the LME price as the hedged risk, provided it is separately identifiable and reliably measurable. Hedged items General requirements

When identifying the non-contractually specified risk components that are eligible for designation as a hedged item, entities need to assess such risk components within the context of the particular market structure to which the risks relate and in which the hedging activity takes place. Such a determination requires an evaluation of the relevant facts and circumstances, which differ by risk and market. Hedged items General requirements

The Board believes that there is a rebuttable presumption that, unless inflation risk is contractually specified, it is not separately identifiable and reliably measurable, and so it cannot be designated as a risk component of a financial instrument. However, the Board considers that, in limited cases, it might be possible to identify a risk component for inflation risk, and provides the example of environments in which inflation-linked bonds have a volume and term structure that result in a sufficiently liquid market that allows a term structure of zero-coupon real interest rates to be constructed.

Also read on FAQ | IFRS: 

Hedges of exposures affecting other comprehensive income
Aggregated exposures

Hedged items General requirements

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